Confidence appears to be rising again with the European banks.  Euro overnight bank lending rates appear to be normalising and banks are no longer holding as much money with the European Central Bank (ECB) above reserve requirements.  Indicators are that banks have started to lend to each other again which could lead to the ECB speeding up its withdrawal from offering unlimited loans to Eurozone banks (which were shelved last year).  However, many banks in Greece, Ireland and Portugal are not benefiting from the freeing up of inter-bank lending and remain reliant on ECB loans.

The question is, will the signs of  confidence remain after the 2011 EU stress tests devised by the European Banking Authority (EBA) are carried out during the first quarter of 2011 (the results of which are expected in June)?

In addition, will there be more trust and confidence in the results of the 2011 stress tests?  

While the results of the 2010 stress tests gave the much needed boost to the European banks and the economy (notably, Barclays and Lloyds made gains of around 8% of their share price following publication of the results and the Euro made gains against the dollar and yen) there was scepticism surrounding the test results.  The 2010 stress tests were considered too soft and gave no indication of the issues that ensued with the Irish banks at the end of 2010. 

The 2011 stress tests will cover a broadly similar group of banks as last year but this time will run alongside a parallel stress test of insurance companies carried out by European Insurance and Occupational Pensions Authority (EIOPA).  The object of the test will be the same as the 2010 stress tests – to assess the resilience of the banking system, insurance sector and the individual financial institutions within them to hypothetical stress events under certain restrictive conditions.  

However, this time in order to gain trust and confidence in the 2011 stress tests, exposure to sovereign risk should be properly tested against both the banking book and the trading book, with sovereign default being at least a possible adverse scenario.  In addition, a more challenging tier 1 ratio target should be used than the previous 6% target, particularly in light of the fact that the minimum tier 1 capital ratio will be 7% (4.5% minimum requirement and 2.5% capital buffer) for banks to be free from restrictions on bonuses and dividends under the Basel III Rules.  Likewise, trading book shocks should be more conservative this time.

Additionally, each financial institution should fully disclose how the scenarios have been interpreted and assumptions have been made, with a uniform approach be applied as far as possible. 

Importantly, the scenarios should also include the potential withdrawal of the unlimited loans to Euro banks provided by the ECB, which is becoming a more realistic scenario.  It is important to assess, in any event, how banks could survive independently of any support for the sake of long term confidence.

One of the most likely outcomes that the market will be expecting from this new round of stress testing will be more failures and a larger shortfall. Only seven banks failed last time round – which was lower than expected, and in addition, during the last tests the banks only needed to raise Euro 3.5 billion against an expected Euro 30 billion shortfall The market will also expect the test results for Greece, Ireland and Portugal to be realistic.

The question will be, with the required improvements to the tests, will the initial signs of confidence continue in the banking sector following the results?  This may not be the case in the short term, but this should not prevent the improvements from being made.  While the results are unlikely to be as impressive as previously, at least the tests will be more transparent and more realistic and, even if in the short term they have an adverse effect on confidence in the banking sector, it should be beneficial in the long term.